Last September I joined the GitLab team and received stock options. I knew what that meant at a very basic level but I didn't have a clue about the details. I've also noticed a lot more discussion on Twitter about stock options and what it means for employees. There is still a lot of confusion around the topic. Part of the problem is that many of us have heard the terrible stories about early-stage startup employees who missed out on millions of dollars when their company sold or after the IPO because they couldn't afford to exercise their stock options. Or maybe you saw the news about Good Technology where employees lost hundred thousands after their company sold.
I think it's safe to say that none of us want to be the person who misses out or loses a lot of money. That's why I set out to learn as much as I could about my stock options and what the best strategy is for me. I will share what I've learned and even try to provide some general advice or direction. However, it's important for you to understand that I'm not an expert on this topic and my advice is not a substitute for professional advice. I spent several hours talking with my financial advisor and my accountant and you should, too.
The advice here is based on U.S. tax law and incentive stock options (ISO). Options granted to employees in other countries will be under entirely different tax laws.
Stock options are part of your compensation package
Stock options should be evaluated as part of your larger compensation package. However, they should not be confused with salary. If employees own stock in their company, in theory they are incentivized to help increase the value of the company, which will increase the value of your stock. Stock options give the holder the option, but not the obligation, to purchase the stock in the future. If the option holder purchases the stock they are said to have "exercised their options."
Your stock options probably have a vesting schedule that you need to be familiar with. A common schedule is vesting over 4 years with a 1 year cliff. This means that when you start at the company, although you were issued X number of options, you are not entitled to any of those options up front. After 1 year (the cliff) 25% of your options will vest - you're now entitled to them. Every month after the first year your options will vest monthly. This means your remaining options vest at approximately 2% per month. By the end of year 4 you are 100% vested. If at any point during this vesting schedule you are terminated then your unvested options are forfeited immediately. You are able to exercise (purchase) any vested shares for a defined period of time after your termination. The window is generally 90 days, which isn't a lot of time.
It's important to understand the vesting schedule and the 90 day exercise window upon termination. I'm sure you don't plan to be fired or leave the company if you're just joining. However, if you are aware of your options and you plan wisely on when to exercise then it should not lead to extra surprise.
Some companies offer early exercise terms. Even though you have unvested shares, they will allow you to exercise the options before they vest. This is a really nice opportunity that companies offer because it starts the clock on some important tax rules. We'll discuss the tax rules later. There is a catch when you purchase unvested shares. Remember what I said about unvested shares before? You're not entitled to them until they vest. If you choose to purchase early the company retains the right to repurchase those shares at strike price if you're terminated. Even if there is a spread between strike price and current market value the company will repurchase the shares at the lower value.
Taxes are probably the place you need to spend the most time scrutinizing the details. You may not be able to afford the costs associated with exercising your options. Why? Taxes. It's hard to understand because the strike price of options is usually very low.
Let's lay out a scenario. You were granted the option to purchase 10,000 shares at $0.50 per share. That's $5,000. Many employees can save up $5,000 to exercise shares at some point - no problem. However, in some situations the taxes as a result of exercising those shares could far surpass value. Note that if you choose not to exercise your shares, there are no tax implications to be concerned with.
The crux of the problem for employees is this thing called Alternative Minimum Tax (AMT). Most people have never heard of AMT because they don't make enough money or have large investments to trigger AMT. You could find yourself triggering AMT if you exercise your shares and aren't careful, Here's how.
At the time your options are granted, the market value and the strike price are the same. If the company goes through additional funding rounds, gets acquired, or goes through an IPO, the market value of your stock will (hopefully) increase. The difference between the new market price and your strike price is called the spread. The IRS views this spread as a sort of income, even though you don't receive any money in your pocket as a result. Whether this 'income' causes tax problems for you is complicated. The spread will not be calculated as regular, salary type income for your normal tax calculations. However, it is part of the AMT calculation.
I don't fully understand how to calculate AMT but I can give you some rough examples of what it might look like. Let's consider a simplified example where you earn an annual salary of $100,000. You pay income tax on this amount. Most people have an AMT amount that is lower than their salary. Let's say your AMT tax amount is $50,000 when we don't consider your shares. In this case the AMT amount says you must pay taxes on at least $50,000 of your income. However, since your regular income amount is higher, you pay the higher amount.
Now let's consider what happens if you exercise all 10,000 of your options at the strike price of $0.50 per share. The exercise price of your shares is $5,000. Additionally, your company underwent large funding rounds and the market value of the shares is now $10. Your shares are now worth $100,000. The spread is $95,000. Add this to your previous AMT and you have $145,000. Since the AMT amount is now higher than your regular income you trigger AMT. It means you pay $100,000 in regular taxable income from your salary plus $45,000 in AMT income. AMT tax rates are different than your normal tax rate and vary anywhere from 26% to 35%. You are now required to pay an additional $11,700 to $15,750 in taxes. This is often referred to as a phantom income tax because you're paying taxes on income you haven't actually realized yet.
The above situation is pretty extreme. Most companies probably aren't going to rapidly achieve a $10 share price. But this is just an illustration. You may have been granted far more options, and at a different strike price than I mentioned. When you hear the stories about people being unable to exercise their shares due to the tax burden, this is why.
An additional note about AMT and taxes: If you exercise options and the stock price then decreases in the future, you can claim a tax credit for your investment loss on the price of the shares themselves. However, your AMT payment is not similarly deductible. Don't confuse the two. There is an AMT credit that is available in some cases, at the sale of your stock. The specifics surrounding this are complicated and beyond the scope of this post.
Limiting the tax burden
If you purchase your options early and the strike price and market price are identical, or at least very close, you can avoid triggering AMT.
If you choose to early exercise, file an 83(b) election form, especially in cases where the strike price and market value are equal. The 83(b) election tells the IRS you want to be taxed on your shares at the time of exercise. Although paying taxes early doesn't sound like a good proposition, it is in this case. Otherwise the IRS will tax you when your shares vest. As your shares vest over a 4 year period it's likely the market value will increase over that time. If the spread is so great that it triggers AMT, you'll end up paying a ton in taxes as described before. If the spread is $0 when you exercise, and you file the 83(b) election within 30 days of exercising, $0 will be added to the AMT calculation.
An added benefit of early exercise is that you start the capital gains clock early. If you hold on to your shares for at least 2 years from the date of grant and 1 year from the date of exercise, the IRS will tax you at the capital gains tax rate if/when you sell the shares. If you sell prior to the 1 and 2 year timelines you will be taxed at your normal tax rate. The capital gains rate is 15% for people in the 25-35% tax bracket.
Exercise up to where AMT equals regular tax
When you don't have the luxury of exercising your options before the market price increases you can purchase options up to the point where AMT is triggered. This limits your tax burden while still giving you flexibility. Still, the earlier the better if you choose this option. If your company does really well and the valuation increases too much you may have trouble exercising options while still avoiding AMT. Talk to your tax accountant for help calculating your current AMT so you know how many shares you can purchase.
If you're early exercising your options when the market price is higher than the strike price be sure to file your 83(b) election just like you would with the early exercise when the prices were equal. Remember, filing this form means you intend to pay taxes up front as opposed to when the shares vest. You can reasonably assume that the spread will be higher when your shares vest than at the time you purchased. This decreases your chances of triggering AMT, too.
An 83(b) election is not valid when purchasing fully-vested shares.
As long as your company is private you need to understand that your shares are not particularly liquid. That is, you can't easily sell them. When your company is public you can trade on the open market, freely. Private companies generally have a right to first refusal on any sale of their stock. This means you will have to give the company the option to purchase your shares back from you before you can offer to sell or give them to another party. You should expect to invest in your company for the long haul.
I definitely believe that early exercise is the way to go. I plan to exercise my options early, but in chunks. It's important to remember your options are not all or nothing. You can exercise in smaller chunks so you don't over-extend yourself. Remember to keep a level head and do what's best for you based on your current financial situation. Never take out a loan to exercise. That's way more risk than most people should be taking on.
Finally, thanks to GitLab's public handbook, you can see many of the specific details about the employee stock options they grant. Although your company may not be as open with the public, you should have access to similar information accompanying your options grant. Be sure to refer to these documents when trying to determine the best course of action for your situation.
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